Soft
Commodities: Grains

The great commodities bull
of the 21st century has elevated individual commodities and sectors
of commodities in various phases over the last eight or so years.
Those commodities that are finite (hard commodities) took the
lead, with energy and metals breaking out to historic highs.

Growing global demand led by
Asia's industrialization has pinched the supplies of these scarce
resources. And this has caused an economic imbalance that has
birthed massive secular bull markets across the entire energy
and metals complexes.

With hard commodities leading
the way, it was only a matter of time before the soft commodities
followed suit. Soft commodities are those resources that are
renewable. If it can be grown, whether plant or animal, it is
considered a soft. But even though softs are renewable, it doesn't
mean they can't experience economic imbalances.

There is a wide assortment
of soft commodities ranging from cotton, to pork bellies, to
wheat, and even wood pulp. But in this essay I will focus on
the grains side of the trade. Grains are the bellwethers of the
softs and it is these agricultural commodities that nearly 150
years ago shaped the whole market for futures trading.

Today farmers rely on futures
markets to lock in prices and manage their inventories. And speculators
play the futures game in an attempt to score profits. The symbiotic
relationship between farmers, speculators, and the vibrant fundamentals
of the grains forms one heck of an exciting market environment.

Supply and demand are of course
the driving forces behind all long-term price trends. And provocatively
the dynamics that have led to what is shaping up to be a growing
global grains imbalance come from underlying trends that have
long-been in the works. These trends are now apparent and the
markets are really starting to take notice.

Over the last several decades
a whole slew of factors have provided catalysts for the rise
of the grains. With one of the largest being the lack of material
growth in the agricultural industry. And considering the long-time
behavior of grains prices, it is understandable why there has
been little incentive to grow this industry.

When the price of any good
or service grinds sideways for decades on end while the rest
of the world is inflating away, this tends to harbor dismal growth
prospects. And this is typically not an encouraging environment
for capital investment. In fact if the fruits of the land are
not as appealing as an offer from a commercial developer, a prudent
business operator will take the money and run.

While technology improvements
over the years have indeed enabled better crop yields, according
to the US Department of Agriculture the US planted area for the
major crops has dropped by nearly 15% since 1980. And since the
US is the stalwart of global grains producers, this trend has
had a major adverse effect on the global agricultural industry.

But with flat grains prices
over the last several decades, you can hardly blame the farmers
for capitulating. Government subsidies only go so far as rapidly
rising costs mixed with a declining dollar strangle the farmers'
ability to run profitable businesses.

Even the USDA has acknowledged
that "stable" food prices over an extended period of
time have led to complacency in the agricultural industry. This
complacency ranges from lack of investment at the individual
farm level all the way to gross mismanagement of stockpiles by
the world's governments. As all this comes to a head we find
an industry that is scrambling to right the ship and adjust to
this global commodities bull.

The simple fact is the world's
population continues to grow, and so does the demand for staple
foods. So with the primary end product of grains being food,
supply needs to keep up with growing demand. And it is not! Supplies
have been growing, but not sufficiently enough to meet demand
growth.

And to put a twist into this
supply/demand imbalance, segmented economic prosperity is also
changing the dynamics of the grains trade. Economic growth in
the world's developing nations has and will cause extra strains
on the grains. As more and more people add protein and other
valuable nutrients to their diets, grains demand will continue
to gain strength.

Not only will the demand for
grains as direct food consumption grow, but so will their demand
for use as animal feed. Land animals, while long thought to be
delicacies in many developing nations, will become staples for
a lot more households. Interestingly the demand for animal feed
greatly leverages the demand growth for meat.

Cows and hogs require about
seven pounds of feed to produce one pound of meat. And as the
demand for animal byproducts continues to grow (i.e. eggs and
dairy) even more grains will be required in order to satiate
what should be sharply growing global demand for protein.

Also a big factor weighing
on the grains is the increasing demand for biofuels. As energy
prices continue to rise, alternative sources of energy become
economically viable. And while biofuels haven't quite found their
economic balance, their production has ramped up to a much larger
scale, thus greatly drawing on the already tight grains supplies.

These factors are just some
of the structural issues that the agricultural industry must
address. And these main ones don't even begin to address other
interim factors that weigh on this industry year-in and year-out
such as climate changes, water shortages, disease, and growing
speculation to name a few.

Drilling down on specific grains
it is corn, wheat, and rice that account for nearly 90% of the
world's grains production. And some experts estimate these grains
are responsible for nearly half the calories people consume each
year. Also for the purposes of this essay I will lump in soybeans
in my analysis of the grains. Though soybeans are officially
classified as a legume, traders usually put them in the grains
category from a global trade perspective.

As I'm sure you've noticed,
the prices for these grains have skyrocketed in the last couple
years. From their 2006 lows corn, wheat, and rice are up 271%,
234%, and 200% respectively to their recent highs. Soybean prices
are also up over 200% since this soft began its run in late 2006.

Ultimately since the main crops
of the US are corn, wheat, and soybeans and since these softs
also get the most exposure from US traders, this is where I will
center my attention. Though rice has a large global following,
the US doesn't make a dent in its production or consumption.
And as people add more protein and nutrients to their diets,
wheat especially will take demand away from rice.

This first chart shows why
all the excitement is around the main grains of recent as corn,
wheat, and soybeans have all had spectacular runs. But this short-term
chart doesn't capture the historical meaningfulness of these
breakouts. In addition to some fundamental analysis, it is important
to view the long-term charts so we can see how today's nominal
highs compare historically.

As will be apparent in the
long-term charts the grains have been range-bound in sideways
trend channels for the better part of the last four decades.
Every so often there were strong rallies that elevated prices,
but they quickly fell back within trend.

But what we are seeing in the
last couple years are major breakouts from these trends. Is it
possible that these decades-long trends will be broken for good?
Are we in a new era for the soft commodities? And what are the
potential impacts continuing high grains prices will have on
the markets?

Let's look at corn first, as
it has really been the focal point of the grains in recent weeks.
With the US being the largest corn producer and consumer in the
world, the recent major flooding within its heartland corn belt
is really hurting the already tight corn market.

These weather problems mixed
with a number of other factors are contributing to a corn price
that is right now nearly going parabolic. So far in 2008 corn
has risen by over 60% and it has already well-surpassed its all-time
nominal highs.

One of the biggest contributors
to corn's rise is its use in biofuels, in particular ethanol.
In the US ethanol's feedstock primarily comes from corn. And
ethanol production in the US has been skyrocketing. This is partly
due to the perceived economic benefits of ethanol but primarily
due to the mandates set forth by the US government.

The Energy Policy Act of 2005
and the Energy Independence and Security Act of 2007 are statutes
that mandate an increase in biofuel volume to supplement gasoline
consumption. This has of course caused a sizeable shift from
food and feed over to ethanol. In fact the USDA reports that
corn use for ethanol has more than tripled in the last five years
and that the biofuel craze now consumes a quarter of all US corn
production!

And things don't get any better
from here. Ethanol production volume from corn needs to nearly
triple again from last year's number by the year 2022. The USDA
expects this trend to command one-third of the corn crop by 2010
and onwards from there. Provocatively ethanol production at these
future mandated volumes will still be less than 10% of gasoline
use in the US.

Ethanol is really tightening
up the market for corn. And it is apparent that this biofuels
impact has spread to greatly affect the fundamentals of the other
grains as well. Eventually the US government will realize that
its communist-style mandates are directly contributing to rising
food prices.

This can be really damaging
to not only the US economy but the global economy. If the government
thinks people are upset about the cost of filling their vehicles,
just wait until it experiences the wailing and gnashing of teeth
when food prices go through the roof.

On a side note if the government
ever decides to fix its mess, a temporary or permanent freeze
on its ethanol mandates would send waves through the grains markets.
Foolish Acts of Congress such as these really display the politicians'
lack of understanding of economics and free markets!

Ultimately these are just some
of the factors that contribute to corn's meteoric rise and build
a case for high corn prices going forward. But in looking at
the next chart, is history going to repeat itself and crash this
spike back into corn's long-grinding sideways trading pattern?

Since 1970 corn has been range-bound
and has averaged a price of just under $2.50. Every so often
this price would approach $4 and dip below $2, but overall it
has been steady in this range. Other than a brief trip above
$5 in 1996, corn has been sliding sideways for decades on end.

But with the recent spike above
$7, many people are wondering if the days of cheap corn are behind
us. While I do believe corn may be a bit overbought and due for
a correction to balance sentiment, are the prices we see today
really all that excessive from a historical context?

To answer this question we
need to consider inflation's effect on corn over time. And in
looking at this chart you can see that corn is actually still
cheap. Using the US Consumer Price Index we can inflate corn's
nominal price history. And with a little bit of math we get the
blue line that shows corn's price in constant 2008 dollars over
the last 37+ years.

Interestingly in today's dollars
corn was above $7 for much of the 1970s and early 1980s. So measured
by the past, $7 corn is not unfamiliar territory. And while corn
may indeed be at its nominal highs today, it still has a long
way to go before it reaches its real high near $17.

Moving on to wheat, this grain
has also had quite a run in recent years. A big catalyst to wheat's
precipitous rise that took it parabolic into February was when
traders realized its 2008 beginning stocks were at their lowest
levels in 30 years. Beginning stocks are carryover from the previous
growing season, and when the alarming numbers from 2007's ending
stocks came together, panic hit the markets.

Also hurting wheat production
was adverse weather conditions over the last couple years as
well as a major US crop planting shift to account for the increasing
production of biofuels. In the cropland that can be interchangeable
between corn and wheat, many wheat farmers shifted to planting
corn based on increasing demand and a forecasted rise in price.

Like the other grains the price
of wheat had been bouncing around in a sideways pattern for decades
on end. With the average wheat price (Kansas City, #2 grade hard-red
winter) at $3.75 since 1970, the nominal prices above $9 we are
seeing today are virtually unprecedented.

While wheat would spend seasons
bouncing around in this trend between about $2 and $5, these
recent breakout highs have sure caught the world's attention.
My business partner Adam Hamilton wrote a fascinating commentary
on wheat
and inflation in the midst of its rise last autumn, and I
encourage you to peruse it if you are at all interested in this
popular soft commodity.

So far since its low of $2.60
in 2000, wheat has risen by over 400%. And while wheat has corrected
since its February highs of around $14, it is still well above
multi-decade resistance. But in adjusting the price of wheat
for inflation, these nominal highs are nowhere near real highs.
Using the CPI to inflate wheat's price over time, in constant
2008 dollars its real high from the early 1970s is over $28!

Well with the price of wheat
way up, record production is expected to meet record consumption
in 2008. And this brings up an interesting grains characteristic,
their adaptability. Because grains are renewable and have crop
cycles that span just a season, farmers sometimes have the ability
to make ad-hoc adjustments on a year-over-year basis. Simply
put if there is a major shortage, more wheat can be planted.

But this flexibility comes
with consequences. Planting area increases in wheat might decrease
the planting area for say soybeans, and vice-versa. This characteristic
is really apparent when you view a chart of each grain's annual
planted acreage.

In a recent forecast by the
USDA you can see corn and soybean planting down and wheat up
this year to account for the major shortages. But going forward
the USDA expects wheat and soybean planting acreage to continue
trending down while corn's rises thanks to ethanol.

This trend actually began in
the mid-1990s for wheat. And by 2006 there was 25% less acreage
dedicated to wheat than just ten years prior. This is a huge
decrease considering that the US is the world's third-largest
wheat producer and its top exporter. If the conservative USDA
expects low stocks and high wheat prices to persist for the next
decade, which it does, then there could be a lot of room to run
for this grain.

Finally we get to soybeans,
which are a soft that has grown increasingly popular over the
years. Interestingly early in the 20th century most farmers in
the US didn't give soybeans a second thought. But after planting
conditions proved favorable and global demand continued to rise,
soybeans eventually became this country's largest exported commodity.

Today the US is the world's
top producer and exporter of soybeans, by a measure of two-fold
over the next largest producing country Brazil. And measured
by trading capital soybeans are by far the largest cash crop
in the US, well surpassing any of the grains.

The global demand growth for
vegetable oil and protein meal from soybeans is well outpacing
supply growth today, which is why the price of soybeans is at
a record high. And the cause for this imbalance is the same old
story. Global stockpiles are at historic lows, the planted area
is down, and there is growing creepage from the grains crops
that produce biofuels.

As you can see in this chart
soybeans have also long been range-bound in a sideways trend
channel. Since 1970 soybean prices have largely languished around
the $5 level with the occasional climb to the top of resistance
near $9.

With the average soybean price
since 1970 just over $6, the $14 we see today has gotten folks
really excited about this commodity. But though today's price
levels are nominal all-time highs well above long-term resistance,
there is still a long way to go before this bean gets near its
real high of $60.

Ultimately the fundamentals
are stacked up nicely for ongoing bull markets in the grains.
Demand growth and supply growth remain tight and it will take
many years for the agricultural industry to balance crops between
food, feed, and biofuels, properly manage crop acreage growth,
and adjust to the radical change of diet for a large part of
the world's population.

But there is one glaring factor
that is likely to keep grains prices high regardless of the fundamentals
already mentioned. And this is skyrocketing operating costs.
The sharply increasing costs of doing business in the agricultural
industry should put an end to the decades-long "stability"
of grains prices.

When powerful and historically-unprecedented
commodities bulls in the hards take shape, it is a certainty
that there will be a trickle-down effect into the rest of the
commodities. Since it takes commodities to produce commodities,
operating costs will naturally rise. With costs rising faster
than any subsidy can begin to cover, it is inevitable that the
price of the end product will rise.

For the grains this pass-through
commodities inflation starts from the beginning of their lifecycles.
From seeds, fertilizer, and chemicals to grow the crops, to fuel
and power to get these crops market ready, costs are skyrocketing.
Using corn as an example, an estimate from the USDA has these
components alone accounting for 86% of operating costs and 45%
of total costs when overhead (labor, land, etc) is thrown in.

And what is frightening is
these USDA figures are from a 2007 forecast. Since this official
forecast these input costs have just skyrocketed. The farmers
simply cannot absorb cost increases for such inputs as oil and
potash among the many others. Costs must be passed on to the
consumer.

And then when you throw in
transportation costs, it is easy to see how this becomes a global
issue. Of course ground freight and rail costs have risen with
fuel, but ocean freight rates for dry commodities have gone through
the roof.

Ultimately there is a lot more
that goes into the grains trade than what I highlighted today.
But in understanding that there are structural conditions that
scream for an end to cheap grains prices, we can now look to
this sector for trading opportunities.

At Zeal we have focused on
trading the commodities markets since 2000. Much of our attention
through the years has been on the metals and energy markets.
For the average investor that only invests and/or speculates
in the stock markets, there has been a broad array of opportunities
to leverage the secular bulls of metals and energy by buying
the stocks and/or options of those companies that explore, develop,
mine, or drill for these commodities.

Legendary gains have been won
in the hards and these commodities are still likely to thrive
for at least another decade as supply continues to struggle to
meet demand. And it has certainly been fascinating to watch how
the bullish fundamentals of the hards have cascaded into the
entire commodities complex.

It was only a matter of time
before the softs joined the parade, but there have been limited
opportunities for stock traders to participate in these newest
bull markets. Publicly traded farmers simply don't exist and
it would not be feasible to hoard physical grains. Up until recently
only the futures traders and offshoot servicers of the agricultural
industry have been able to play the grains game.

But new trading vehicles have
surfaced in recent years that now allow stock traders to gain
direct exposure to the grains. A number of ETFs and ETNs have
hit the markets that either track or directly invest in futures
contracts of the high-profile soft commodities. There are ETFs/ETNs
that specifically invest in the grains detailed in this essay
as well as those that provide broader exposure to the realm of
the softs. And there are even those that provide double leverage
on both the long and short side.

At Zeal we believe there are
still fortunes to be won trading the softs, in particular the
grains. In our newsletters we have long discussed the impending
food inflation crisis. And with these new agricultural ETFs and
ETNs we are able to freely invest and speculate in these markets
without the risks and hassles of futures trading.

In recent months we have deployed
newsletter trades to test the resolve of these hot softs markets
and we continue to formulate future trading strategies with the
help of excellent new exchange-traded tools. If commodities are
at all intriguing to you, please subscribe to our acclaimed monthly
and/or weekly newsletters so you can access cutting-edge commodities
market analysis and high-potential stock recommendations.

The bottom line is the bull
markets in the grains are righteous. Not only are there interim
factors that are driving prices higher, but there are long-term
trends that justify breakouts from the grains' long-grinding
sideways-moving prices.

With demand growth outpacing
supply growth, global diet changes, a huge rise in biofuel demand,
and skyrocketing operating costs among many factors, the days
of cheap grains are likely over. And stock traders can now utilize
ETFs and ETNs to effectively trade these markets.

Jun 27, 2008
Scott Wright

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Thoughts, comments, or flames? Fire away at scottq@zealllc.com. Depending on the volume
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